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December 9, 2013

Debunking the 5 Top Myths Around Options Strategies

Over the past 10 years, there has been an increase in the use of options strategies. From Dec. 31, 2009, to Oct. 31, 2013, the average monthly options volume has increased 83.7% (Source: Options Clearing Council). Conversely, equity market volumes are down are since the credit crisis with the NYSE and NASDAQ off 62.0% and 16.6% respectively (Source: SIFMA).

Despite this growth, investors continue to perceive options strategies to be higher on the risk spectrum than more traditional equity or fixed income strategies. In addition, investors note high execution costs and the necessity for proper timing as reasons for caution. This month, we seek to analyze the drivers for investor reluctance to use options and aim to debunk the myths that exist regarding options-based strategies. To do so, we categorized these fears and concerns by comments most commonly made by investors regarding options.

Myth 1: “I know someone that lost a ton trading options”

In reality, this statement is often related to option floor traders and their brethren during the 1987 portfolio insurance bloodbath. Many allocators have since attached a “Don’t Touch” label to anything related to the options market. While outsized loses can occur due to naked or levered positions, many option strategies are actually used as risk mitigation strategies and the risk of loss on the option is no more than the premiums paid.

Myth 2: “Options are for hedge funds and prop desks”

While these entities certainly benefit from the use of options and have supported growth in the space since the early 1990’, their activity has not made options more risky. If anything, an increased institutional presence has provided more efficiency to the trading of options and options. Furthermore, the fact that institutional investors have embraced the flexibility of options for both alpha generation and risk mitigation reasons should increase investors’ collective comfort level about the viability of options.

Myth 3: “I don’t understand options/the Greeks”

Many investors today began their careers before options trading became part of everyday parlance in the financial markets. Today, news and print media coverage includes updates on trends and trading strategies utilizing options and futures. The days of the traditional 60/40 portfolio using stocks and bonds, while not gone, are dwindling. Investors of today must consider a multitude of asset classes and vehicle structures that were not commonly found in portfolios a mere 20 years ago.

That said, some options-based strategies are complex which might require the use of an investment advisor or a fund manager to manage the options strategy for the individual investor. Portfolio managers would be quick to point out however, that increased complexity does not equal increased risk.

Myth 4: “Derivative and option trading is too expensive”

In the world of high-frequency trading and market making, the cost of derivative programs can fall on the pricier side, but when considered in a portfolio context as a risk management tool (as many derivative strategies are), this cost is applied to more meaningful downside protection.

In today’s environment, where many investors perceive the biggest risk in their portfolios to be related to rising interest rates, the historical diversification properties of fixed income may be diminished by more volatility and asset price depreciation. Going forward, the risk/reward properties of option strategies may prove to be a better “asset class” than bonds in a rising rate environment. In sum, they’re arguably worth any uptick in expense.

Myth 5: “My equity portfolio is up 20% this year, why do I want to cap my upside with options?”

While this response is far less common and primarily directed at covered call, long put option or collar strategies, some investors do believe that the equity rally will continue. In this case, risk mitigation is critical since historically equity selloffs occur faster than the runups that precede them. Unfortunately, these investors often believe they are capable of timing the market, which could be a less than ideal form of risk management.

In all, we find that investors with either experience in trading options or academically driven research backgrounds are more inclined to allocate to products or strategies that employ options. Longer-term holding periods and less concern over taxation are also indicative of greater acceptance of the value of options-based strategies. Fortunately, more and more investors, advisors and analysts are aware of the benefits of incorporating options into strategic portfolio allocations. Combined with the growing demand for fixed income substitutes and portfolio level risk management tools, interest in volatility-mitigating options strategies may be nothing more than a 10% correction away.

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